The Two Markets

the simple mechanics

We move to our simple model of the economy, the Circular Flow, to which we will progressively add elements. In this way we will gain closer approximations to reality. We can also add and subtract pieces in order to get a better idea of how things were in other time periods. The Circular Flow is the basic model of a functioning economy with a division of labor.

By division of labor, we mean that production and consumption are separated, and they take place in different entities. Production takes place among enterprises, businesses; consumption takes place in households.

These two sides are in balance. Looked at from the perspective of the total economy, the goods and services that are produced, are produced by the same work force that, in turn, consumes them. This brings production and consumption in balance; monetarily, remuneration (salaries, fees, etc.) are enough to pay for the entirety of production. According to what has come to be known as Say’s Law (after its originator, Jean-Baptiste Say), total production necessarily generates an equal quantity of total consumption; or, in the usual formulation, “supply creates its own demand.”

This relation is represented in figure 1.

Simple Circular Flow
 Figure 1: Simple Circular Flow